How does hyperbolic discounting affect financial well-being?

One key concept in behavioural science is hyperbolic discounting, a topic I've written about in the past and on which I focused my Ph.D. Hyperbolic discounting is our tendency to focus more on immediate rewards, than on those in the distant future. This bias helps explain why people spend money on an expensive holiday rather than saving money for future needs. Here are three examples of how hyperbolic discounting affects our financial well-being:

1. Impulsive buying: We might display a pattern of overspending on things we don't need because the immediate joy feels more rewarding than the abstract idea of saving for the future. This impulsive behaviour can lead to unnecessary expenditures and debts.

2. Difficulty maintaining long-term financial goals: Hyperbolic discounting often causes us to prioritize immediate gratification over long-term financial goals. For instance, we may choose to go on a fancy vacation instead of investing that money in our pension. This makes it challenging to consistently save money for retirement or other long-term financial needs.

3. Credit card debt: We might use our credit cards to make purchases we can't afford, intending to pay them off later. However, when the bill comes due, we often find ourselves unable to pay the full balance, leading to accumulating interest charges and debt. This cycle can create long-term financial stress and reduce our ability to achieve financial stability.

What are some behavioural strategies to combat hyperbolic discounting?

1. Plan: Create a detailed plan outlining specific steps to achieve long-term goals. For example, if we want to save money for a trip, we can create a budget to ensure we stay on track. Having a clear plan can provide a sense of direction, helping us stay committed to our financial goals.

2. Precommitments: These involve making a decision in advance that binds us to a particular course of action. By limiting our future choices, we can protect ourselves from impulsive decisions. For example, committing to a long-term savings plan ensures consistent saving and encourages disciplined financial behaviour.

3. Automation: Setting up automatic investment plans creates a structured approach to saving and investing, reducing the temptation to divert funds to short-term pleasures. Automatic plans remove the need for constant decision-making, making it easier to stick to our long-term goals.

Behavioural science plays a crucial role in understanding financial decisions. Financial institutions can implement these principles to help people develop healthier financial habits.